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The New 20% Pass-Through Deduction of the Tax Cuts and Jobs Act - Impact of Choice of Entity Decision and Business Owner’s Income

One of the most talked about items in the newly passed Tax Cuts and Jobs Act is the deduction available to owners of pass-through entities under Code Section 199A. As discussed in this Client Alert, an interesting quirk with this provision is that the type of pass-through entity used by the business owner – and the income level of the business owner – may lead to different tax results. Please contact your primary Ulmer relationship attorney or one of the lawyers listed in this alert to discuss how these provisions impact you and your business.

Briefly, pass-through entities are sole proprietorships, partnerships and S corporations. New Code Section 199A allows the owner of a pass-through entity to claim a below-the-line deduction equal to 20% of the owner’s “qualified business income” (“QBI”). Certain income thresholds and phase-outs/phase-ins apply if the business is a “specified service trade or business” (generally involving the performance of professional services including health, law, accounting, consulting, financial services and brokerage services). Also, at certain income thresholds, the deduction is limited to the lesser of 20% of QBI or 50% of W-2 wages attributable to the trade or business and allocated to the taxpayer (the “W-2 Limit”). (There is also an alternative W-2 Limit based on 25% of the W-2 wages plus 2.5% of the original cost basis of tangible depreciable property.) Generally, QBI is reduced by amounts paid as reasonable compensation to S corporation shareholders and guaranteed payments made to partners in a partnership.

As illustrated by the chart below, the amount of a taxpayer’s taxable income determines which limits and phase-outs/phase-ins apply to the Section 199A deduction.

What follows are examples that show how a business owner’s choice of entity decision – and income level – can lead to different results. The first set of examples is for a high income business owner, and the second set is for a lower income owner.

HIGH INCOME BUSINESS OWNER

Assume the following simplified facts for three different business entities: Mary earns $600,000 of QBI in her non-specified service business, is a single filer, has no depreciable assets, and has no employees.

Sole Proprietor (e.g., single-member LLC disregarded entity)

Mary is eligible for the 20% deduction, but because she exceeds the taxable income threshold, her deduction is fully subject to the W-2 Limit. Since Mary is a sole proprietor, by definition she cannot pay herself a salary, and she does not pay wages to any employees. As a result, Mary’s deduction is $0 due to the W-2 Limit.

S-Corporation

Assume the same facts as above except that Mary runs her business as an S corporation. Mary must receive reasonable compensation for her services provided to the company. The company pays Mary wage compensation of $150,000. This compensation payment reduces her QBI from $600,000 to $450,000. Since Mary is still above the taxable income threshold, she is subject to the W-2 Limit. Reasonable compensation payments to S corporation owners count towards the W-2 Limit. So, Mary is eligible for a deduction of the lesser of 20% of QBI (20% x $450,000 = $90,000) or 50% of her share of W-2 wages paid (50% x $150,000 = $75,000). Here, Mary qualifies for a $75,000 deduction.

Partnership (including a multiple-member LLC)

Assume the same facts as above except that Mary operates her business as a 99% owner of a partnership with her sister owning the remaining 1%. The partnership pays Mary a guaranteed payment of $150,000 for services provided to the partnership. This guaranteed payment reduces her QBI from $600,000 to $450,000. Since Mary is still above the taxable income threshold, she is subject to the W-2 Limit. Guaranteed payments to partners do not count towards the W-2 Limit. So, Mary is eligible for a deduction of the lesser of 20% of QBI (20% x $450,000 = $90,000) or 50% of her share of W-2 wages paid (50% x $0 = $0). As a result, Mary’s deduction is $0 due to the W-2 Limit. Even if Mary did not receive a guaranteed payment, her deduction would still be $0 due to the W-2 Limit.

LOWER INCOME BUSINESS OWNER

If we change the facts so that Mary earns $150,000 of QBI in her business, the choice of entity decision leads to different results.

Sole Proprietor (e.g., single-member LLC disregarded entity)

Mary is eligible for the 20% deduction on her QBI of $150,000 and is not subject to the W-2 Limit. As a result, Mary’s deduction is $30,000 (20% x $150,000).

S-Corporation

Mary is eligible for the 20% deduction on her QBI, but her QBI must be reduced by the reasonable compensation she must receive for service to the company. If Mary receives wage compensation of $50,000, her QBI is reduced to $100,000. Mary’s deduction is $20,000 (20% x $100,000).

Partnership (including a multiple-member LLC)

Mary is eligible for the 20% deduction on her QBI, but her QBI must be reduced by the guaranteed payment that she is paid by the partnership. If Mary receives a guaranteed payment of $50,000, her QBI is reduced to $100,000. Mary’s deduction is $20,000 (20% x $100,000). Also, note that partnerships are not required to pay guaranteed payments to partners. If Mary does not receive a guaranteed payment, her deduction is $30,000 (20% x $150,000).

As demonstrated by these simplified examples, a business owner’s choice of entity decision – and the business owner’s income level – leads to different deduction results under new Code Section 199A. Ulmer attorneys are well versed in the new tax law and other considerations in choosing the best choice of entity for your business.